Finance

In Search of CausesC.P. Chandrasekhar

October 22, 2008

As the financial crisis in the advanced economies intensifies, analyses of the causes of the crisis and its sources have multiplied. The complexity of the financial sector resulting from financial integration at many levels—markets, institutions and instruments—has meant that there are multiple elements to the crisis as it unfolds. Different analyses, therefore, focus on different elements depending on their concerns and timing, adducing different causes. There are, however, strands that when knit together provide a holistic picture.

There is a degree of implicit agreement that the crisis can be traced to forces unleashed by the transformation of US and global finance starting in the 1970s. Prior to that, the US financial sector was an example of a highly regulated and stable financial system in which banks dominated, deposit rates were controlled, small and medium deposits were guaranteed, bank profits were determined by the difference between deposit and lending rates, and banks were restrained from straying into other areas like securities trading and the provision of insurance. To quote one apt description, that was a time when banks that lent to a business or provided a mortgage, “would take the asset and put it on their books much the way a museum would place a piece of art on the wall or under glass – to be admired and valued for its security and constant return.” This was the “lend and hold” model.

A host of factors linked, among other things, to the inability of the United States to ensure the continuance of a combination of high growth, near full employment and low inflation, disrupted this comfortable world. With wages rising faster than productivity and commodity prices—especially prices of oil—rising, inflation was emerging as the principal problem. The response to inflation resulted in rising interest rates outside the banking sector, threatening the banking system with desertion of it depositors. Using this opportunity, non-bank financial companies expanded their activities and banks sought to diversify by circumventing regulation and increasing pressure on the government to deregulate the system. The era of deregulation followed, paving the way for the transformation of the financial structure.

That transformation, which unfolded over the next decade and more, had many features. To start with, banks extended their activity beyond conventional commercial banking into merchant banking and insurance, either through the route where a holding company invested in different kinds of financial firms or by transforming themselves into universal banks offering multiple services. Second, within banking, there was a gradual shift in focus from generating incomes from net interest margins to obtaining them in the form of fees and commissions charged for various financial services. Third, related to this was a change in the focus of banking activity as well. While banks did provide credit and create assets that promised a stream of incomes into the future, they did not hold those assets any more. Rather they structured them into pools, “securitized” those pools, and sold these securities for a fee to institutional investors and portfolio managers. Banks transferred the risk for a fee, and those who bought into the risk looked to the returns they would earn in the long term. This “originate and sell” model of banking meant, in the words of the OECD Secretariat, that banks were no longer museums, but parking lots which served as temporary holding spaces to bundle up assets and sell them to investors looking for long-term instruments. Many of these structure products were complex derivatives, the risk associated with which was difficult to assess. The role of assessing risk was given to private rating agencies, which were paid to grade these instruments according to their level of risk and monitor them regularly for changes in risk profile. Fourth, financial liberalisation increased the number of layers in an increasingly universalised financial system, with the extent of regulation varying across the layers. Where regulation was light, as in the case of investment banks, hedge funds and private equity firms, financial companies could make borrow huge amounts based on a small amount of own capital and undertake leveraged investments to create complex products that were often traded over the counter rather than through exchanges. Finally, while the many layers of the financial structure were seen as independent and were differentially regulated depending on how and from whom they obtained their capital (such as small depositors, pension funds or high net worth individuals), they were in the final analysis integrated in ways that were not always transparent. Banks that sold credit assets to investment banks and claimed to have transferred the risk lent to or invested in these investment banks in order to earn higher returns from their less regulated activities. Investment banks that sold derivatives to hedge funds, served as prime brokers for these funds and therefore provided them credit. Credit risk transfer neither meant that the risk disappeared nor that some segments were absolved from exposure to such risk.

That this complex structure which delivered extremely high profits to the financial sector was prone to failure has been clear for some time. For example, the number of bank failures in the United States increased after the 1980s; the Savings and Loan crisis was precipitated by financial behaviour induced by liberalisation; and the collapse of Long Term Capital Management pointed to the dangers of leveraged speculation. Each time a mini-crisis occurs there are calls for a reversal of liberalisation and return to regulation. But financial interests that had become extremely powerful and had come to control the US Treasury managed to stave off criticism, stall any reversal and even ensure further liberalisation. The view that had come to dominate the debate was that the financial sector had become too complex to be regulated from outside; what was needed was self-regulation.

In the event, a less regulated and more complex financial structure than existed at the time of the S&L crisis, was in place by the late 1990s. In an integrated system of this kind, which is capable of building its own speculative pyramid of assets, any increase in the liquidity it commands or any expansion in its universe of borrowers (or both) provides the fuel for a speculative boom. Increases in liquidity can come from many sources: deposits of the surpluses of oil exporters in the US banking system; increased deficit-financed spending by the US government, either based on the printing of the dollar (the reserve currency) or on financing from abroad; or reductions in interest rates that expand the set of borrowers who can be fed with credit.

Factors like this also fuelled the housing and mortgage lending boom that led up to the sub-prime crisis. From late 2002 to the middle of 2005, the US Federal Reserve’s federal funds rate stood at levels which implied that when adjusted for inflation the “real” interest rate was negative. This was the result of policy. Further, by the middle of 2003, the fed funds rate had had been reduced to 1 per cent, where it remained for more than a year. Easy access to credit at low interest rates triggered a housing boom, which in turn triggered inflation in housing prices that encouraged more housing investment. From 2001 to end 2007, real estate value of households and corporate sector is estimated to have increased by $14.5 trillion.Many believed that this process would go on.

Sensing an opportunity based on that belief and the interest rate environment, the financial system worked to expand the circle of borrowers by inducting subprime ones, or borrowers with low credit ratings and high probability of default. Mortgage brokers attracted these clients by relaxing income documentation requirements or offering sweeteners like lower interest rates for an initial period, after which they were reset. The share of such sub-prime loans in all mortgages rose sharply, from 5 per cent in 2001 to more than 20 per cent by 2007. Borrowers chose to use this “opportunity” partly because they were ill-informed about the commitments they were taking on and partly because they were overly optimistic about their ability to meet the repayment commitments involved.

On the supply side, the increase in this type of credit occurred because of the complex nature of current-day finance centred around the “originate-and-sell” model. Financial players discounted risk because they hoped to make large profits even while transferring the risk associated with the investments that earn those returns. There were players at every layer involved. Mortgage brokers sought out willing borrowers for a fee, turning to subprime markets in search of volumes. Mortgage lenders and banks financed these mortgages not because they wanted to buy into the interest and amortization flows associated with such lending, but because they wanted to sell these instruments to less regulated intermediaries like the Wall Street banks. The Wall Street banks bought these mortgages in order to expand their business by bundling assets with varying returns to create securities that could be sold to institutional investors, hedge funds and portfolio managers. To suit different tastes for risk they bundled them into tranches with differing probability of default and differential protection against losses. Risk here was assessed by the rating agencies, who not knowing the details of the specific borrowers to whom the original credit was provided, used statistical models to determine which kind of tranche can be rated as being of high, medium or low risk. Once certified, these tranches could be absorbed by banks, mutual funds, pension funds and insurance companies, which can create portfolios involving varying degrees of risk and different streams of future cash flows linked to the original mortgage. Whenever necessary, these institutions can insure against default by turning to the insurance companies and entering into arrangements such as credit default swaps. Even government sponsored enterprises like Freddie Mac and Fannie Mae, who were not expected to be involved in or exposed to the subprime market had to cave in because they feared they were losing business to new rivals who were trying to cash in on the boom and poaching the business of these specialist firms.

Because of this complex chain, institutions at every level assumed that they were not carrying risk or were insured against it. However, risk does not go away, but resides somewhere in the system. And given financial integration, each firm was exposed to many markets and most firms were exposed to each other as lenders, investors or borrowers. Any failure would have a domino effect that would damage different firms to different extents.

In this case, the problems began with defaults on subprime loans, in some cases before and in others after interest rates were reset to higher levels. As the proportion of default grew, the structure gave and all assets turned illiquid. Rising foreclosures pushed down housing prices as more properties were up for sale. On the other hand the losses suffered by financial institutions were freezing up credit, resulting in a fall in housing demand. As housing prices collapsed the housing equity held by many depreciated, and they found themselves paying back loans which were much larger than the value of the assets those loans financed. Default and foreclosure seemed a better option than remaining trapped in this losing deal.

It was only to be expected that soon the securities built on these mortgages would lose value. They also turned illiquid because there were few buyers for assets whose values were unknown since there was no ready market for them. Since mark-to-market accounting required taking account of prevailing market prices when valuing assets, many financial firms had to write down the values of the assets they held and take the losses onto their balance sheets. But since market value was unknown, many firms took much smaller write downs than warranted. But they could not hold out for ever. The extent of the problem was partly revealed when a leading Wall Street bank like Bear Stearns declared that investments in two funds it created linked to mortgage-backed securities were worthless. This signalled that many financial institutions were near-insolvent.

In fact, given financial integration within and across countries, almost all financial firms in the US and abroad were severely affected. Fear forced firms from lending to each other, affecting their ability to continue with their business or meet short term cash needs. Insolvency began threatening the best and largest firms. The independent Wall Street investment banks, Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley and Goldman Sachs, shut shop or merged into bigger banks or converted themselves into bank holding companies that were subject to stricter regulation. This was seen as the end of an era were these independent investment banks epitomised the innovation that financial liberalisation had unleashed. In time, closures, mergers and takeovers became routine. But that too was not enough to deal with fragility, forcing the state to step in and begin reversing the rise to dominance of private finance, even while not admitting it. But the crisis is systemic and has begun to choke consumption and investment in the real economy. The recession is here, analysts have declared. Others say a Depression is not too far behind.